A bond is a long term, fixed-income debt instrument that a government or a company issues to raise money. Bonds usually have tenors ranging from 2-3 years, 5-10 years, 10-20 years. Put very simply, bonds are a form of borrowing. If a company issues a bond, the money they receive in return is a loan, and must be repaid over time. The buyers of bonds, then, are essentially lenders. For example, if you have ever bought a government savings bond, you became a lender to the federal government. Put differently, bonds are IOUs. IOU is an abbreviated form of “I Owe You”, it is an informal document acknowledging debt.
Government and corporations commonly use bonds in order to borrow money. Governments need to fund roads, schools, hospital and other infrastructure. Similarly, corporations will often borrow to grow their business, to buy property and equipment, to undertake profitable projects, for research and development. Bonds provide a solution by allowing many individual investors to assume the role of lender.
Of course, nobody would like to lend their hard-earned money for no compensation, the issuer of a bond must pay the investor something extra for the privilege of using his or her money. This “extra” comes in the form of the interest payments also known a coupon payments, which are made at a predetermined rate and schedule. The date on which the issuer must repay the amount borrowed (an amount known as the face value) is called the maturity date. The interest rate associated with a bond is often referred to as the bond’s yield or coupon. In the past, when bonds were issued as paper documents, there would be actual coupons that investors would clip and redeem for their interest payments.
Bonds and stocks are both securities, but the major difference between the two is that (capital) stockholders have an equity stake in a company (that means, they are part owners), whereas bondholders have a creditor stake in the company (that is, they are lenders). Being a creditor, bondholders have priority over stockholders. This means they will be repaid in advance of stockholders, but will rank behind secured creditors, in the event of bankruptcy. Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks typically remain outstanding indefinitely.
CHARACTERISTICS OF A BOND
- Bonds are long term investments, they have tenors ranging from 2-3, 5-10 years or a 10- 20 years.
- Government and corporate entities can issue Bonds
- Bonds are regulated by the Securities and Exchange Commission (SEC)
- Bonds market are not as volatile as the equities market
- Bonds generally have a fixed maturity date.
- All bonds repay the principal amount after the maturity date; however some bonds do pay the interest along with the principal to the bond holders.
TERMS ASSOCIATED WITH BONDS
- Face value is the amount the bond will be worth at maturity and the amount the bond issuer uses when calculating interest payments.
- Coupon rate is the interest rate the bond issuer will pay on the face value of the bond.
- Coupon dates are the dates on which the bond issuer will make interest payments.
- Maturity date is the date on which the bond will mature and the bond issuer will pay the bond holder the face value of the bond.
- Issue price is the price at which the bond issuer originally sells the bonds.